Question of the Week – Equity

Based on the information we are provided, we can use the
Gordon growth model (which is the same model used in the text for this
problem):

P0 = D1 / (r – g)

The justified P/E ratio based on this model is:

P0 / E1 = (D1 / E1) / (r – g) = p / (r – g)

where

p is the dividend payout ratio (20%)

r is the cost of equity capital (11%)

g is the expected dividend growth rate (3%)

We then have:

P0 / E1 = 0.2 / (0.11 – 0.03) = 2.5

The P/E ratio is Price/Earnings Per Share. The stock
price is $35. Earnings per share are $4,000,000 / 1,000,000 = $4. The P/E ratio
then is $35/$4 = $8.75.